You have probably heard that equity is for the “long term”. You have also probably wondered what it actually is.
We wrote an article in 2016 about how long is long term. Much has changed since then. No one really saw 2020 turning out to be the way it is. However, in investing having some idea of what the future is likely to look like is important to a certain extent.
This is especially so as every experienced investment professional says that equity investing requires a fairly long term view. So how long is the long term really and how does this affect your investment behaviour?
The short answer is that the long term is decided by the behaviour of equity according to past data. Two points come forth when we look at the history of equities (in the form of the Sensex) from 1988 to 2020.
i) The longer you held on to equity, the higher the probability of beating inflation
ii) Following from the above, the probability of loss falls with time. While it never disappears it is quite low once you cross the 6-year mark. If we look at even longer horizons the probability is quite likely to drop to zero.
The reasons why we see the above behaviour are multiple. There are business cycles at play that pan out over many years. Companies themselves grow over a period of years rather than days or months. This reflects in stock prices over time.
Equity Markets often price in growth as well as any weaknesses they see in different companies. These are also quite a few times wrong and perceptions change which lead to price changes. Thus we see sharp, or gradual, ups and downs in individual stock prices.
Then there are completely unanticipated events such as the COVID 19 pandemic which can throw a wrench in the business plans of almost every company. They also have a long term impact on the economy and it takes time for this to be factored into the prices of individual stocks.
All these variables play out over years and decades rather than just a few days or months.
Now that we know the factors at play, let us consider what that tells us about the long term by looking at the probability of achieving a target growth rate data, from 1988 till-date,
The recent years have had an impact on this analysis which we also did in 2016. The change in long term inflation trend also means that expected equity returns have to be tempered accordingly. The chart tells us what, according to data so far, is a realistic assumption.
What is the long term based on this analysis?
If we consider our first objective is avoiding a loss, we see that there is a 90% probability of not making a loss from Year 5 onwards. The probability of achieving a growth rate above 10% (this is important considering our growth assumption) is higher starting from the 6-year mark. If we take the average of inflation numbers from 2013-2020, we arrive at 5.35% as the long term average inflation.
This analysis will no doubt change again the next year as new data comes in. What we can conclude with reasonable certainty is that the chances of achieving inflation-beating growth are higher the longer you stay invested.
From a numerical standpoint, this means we are looking at staying invested for 6 years at least to have a 56% probability of beating inflation.
Stay invested in equity for at least 6 years to ensure inflation-beating growth. Have a smart asset allocation plan in place and review your portfolio periodically to ensure you are invested in the right funds.